We
are experiencing one of the worst financial upheavals of the post-WWII
era, driven primarily by a vast increase in the number of mortgage defaults.
But why did the mortgage market meltdown so badly? Why were there so
many defaults when the economy was not particularly weak? And why weren’t
the securities based upon these mortgages considered anywhere as risky
as they actually turned out to be?

In
his new Independent Policy Report, Anatomy
of a Train Wreck: Causes of the Mortgage Meltdown (The Independent
Institute / October 3, 2008), Research Fellow and economist Stan J.
Liebowitz reveals that the federal government has led a misguided attack
on underwriting standards for more than a decade in a politically-motivated
attempt to increase homeownership, particularly for minorities and the
less affluent.

Homeownership
had been stagnant in the U.S. for some time, Liebowitz says. Though
seemingly noble for the government to want to stimulate new ownership,
“the tool chosen to achieve this goal was one that endangered
the entire mortgage enterprise: intentional weakening of the traditional
mortgage lending standards,” he continues.

The
government’s weakened underwriting standards allowed lenders to
grant mortgages with virtually no down payments, few restrictions on
the size of monthly payments relative to income, little examination
of credit scores or employment history, and so forth. Initially these
new rules succeeded in increasing home ownership rates, and “the
decline in mortgage underwriting standards was universally praised as
an ‘innovation’ in mortgage lending,” Liebowitz says.

As
home ownership appeared to become easier, consumer demand spiked, resulting
in a pricing boom at the turn of the 21st century. The rising prices
ushered in a host of speculators, who accounted for roughly a quarter
of sales during this time.

The
speculators would buy and subsequently sell houses over short periods
of time in the expectation of turning a profit, and of course the new
loan standards appealed to them. They pursued adjustable rate mortgages
with the smallest down payments and the lowest interest rates in order
to secure the biggest return. It never mattered how painful these mortgages
might become years down the road, because the home would be sold again
long before then. As borrowers began to default on their loans, though,
the high housing prices began to decrease. When the speculators realized
they could no longer make a profit, they naturally left the market,
leaving the investors who backed them with the mortgage debt. Liebowitz
argues that this hypothesis—rather than the popular subprime vulture
hypothesis—fits much better with the fact that foreclosures increased
mainly for adjustable rate mortgages and not fixed rate, regardless
of whether mortgages were prime or subprime.

It
is necessary to understand what caused the mortgage crisis in order
to avoid repeating history. Many pin the blame for the crisis on greedy
and manipulative lenders or the speculators who bet on the basis of
artificially inflated prices. However, in Anatomy of Train Wreck, Liebowitz
argues that the government-dominated housing and regulatory establishment
is truly at fault. Powerful government agencies and intellectuals must
understand the imperative need for strict underwriting standards. Such
standards are essential safeguards that ensure that housing prices accurately
reflect supply and demand in the housing industry, preventing a housing
bubble like the one that led to the current crisis, Liebowitz concludes.
Lawmakers and government housing officials would do well to understand
this, and they just might manage to avoid such a train wreck in the
future.